Dealings With Qualified Clients and Accredited Investors

January 1, 2012

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Most RIAs are thrilled to see just about any client come through their door. Depending upon an RIA’s business model and investment strategies, however, it may be important to identify which of them are “qualified clients” and “accredited investors.” The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) authorized the SEC to change which clients are defined by the terms of “qualified client” and “accredited investor.” Congress gave this directive to the SEC in Section 418 of the Dodd-Frank Act, because these definitions had not been updated since 1998 and were outdated.

Qualified Client and Performance Fees

Compensation based on capital gains or capital appreciation is usually referred to as performance fees. We saw in Do’s and Don’ts of Advisory Contracts that the statute prohibits RIAs from charging performance fees. The rules interpreting the Investment Advisers Act, however, make an exception for qualified clients.

Performance fees are based on a share of capital gains or capital appreciation of a client’s account. The fees must be fully disclosed and are not permitted unless the requirements of Rule 205-3 are met. The rule states that the provisions of section 205(a)(1) of the Investment Advisers Act do not prohibit an RIA from entering into, performing, renewing, or extending an investment advisory contract providing performance-based compensation, assuming the agreement is with a qualified client.

Thanks to the Dodd-Frank Act, the definition of qualified client found in Rule 205-3 under the Investment Adviser Act of 1940 has changed. The SEC is required to adjust for inflation the financial conditions that must be satisfied in order to be classified as a qualified client. The term qualified client was previously defined as:

a natural person or a company with at least $750,000 under management of the RIA immediately after entering into the contract;

a natural person or a company that the RIA believes has more than $1,500,000 in assets or is a qualified purchaser as defined by section 2(a)(51)(A) of the Investment Company Act of 1940;

a natural person who immediately prior to entering into the contract is an executive officer, director, trustee, general partner, or person serving in a similar capacity, of the RIA; or

a natural person employed by the RIA, other than someone performing only clerical, secretarial, or administrative functions, who participates in the investment activities of the firm and has done so for at least twelve months. An employee may also qualify if that person performed the same or similar functions for another firm for at least twelve months.

An RIA’s advisory contract and Form ADV should state explicitly if performance fees will be charged to a client.

In May 2011, the SEC announced its plan to raise certain dollar thresholds that must be surpassed before RIAs are permitted to charge their clients performance fees. Under the SEC’s proposed rule, a qualified client would be required to have $1 million invested with the RIA or a total net worth of $2 million. Previously, a qualified client was defined as a natural person or company with at least $750,000 under management of the RIA immediately after entering into the contract or a natural person or company that the RIA believes has more than $1,500,000 in assets. The revised thresholds would only apply to new clients, not existing advisory arrangements.

The SEC also proposed to exclude the value of a client’s primary residence from the new net worth standard. NASAA strongly supported the SEC’s proposal, because the value of a client’s home does not necessarily indicate an individual’s level of investment sophistication. Clients who own expensive homes are not necessarily financially experienced and able to bear the risks associated with performance fees.

By July, 2011, the SEC had issued an order on the plan, and on September 19, 2011 the order became effective. As a result, a federally-registered investment advisor may now charge performance fees if a client has at least $1 million under the management of the RIA, or the client has a net worth of more than $2 million. If either of these two tests is satisfied at the inception of the advisory contract, the RIA may charge performance fees.

Although Rule 205-3 permits an RIA to charge performance fees to qualified clients, the fee arrangement must still be consistent with the anti-fraud provisions of the Investment Advisers Act. For an RIA to meet its fiduciary obligation to clients, the fee must be reasonable in relation to the services rendered. The performance fee may not be substantially higher than fees charged by other RIAs for comparable services unless the firm discloses that these services are available elsewhere at a lower cost. In addition, the RIA must disclose all material information relating to the fee, such as how it is calculated.

The rules might be different for state-registered investment advisors. Some states prohibit the use of performance fee contracts by RIAs registered in their jurisdiction, even if the agreement is with a qualified client. In addition, certain states impose restrictions on how performance fees are calculated.

Some states’ rules are a mirror image of the SEC’s. For example, in August 2011, Massachusetts implemented a regulation stating that RIAs may not receive performance fees unless the compensation complies with Rule 205-3. The new regulation stated that advisors are only able to receive performance-based compensation from qualified clients. Massachusetts’ regulation follows the SEC’s lead and defines qualified clients as investors with either $1 million under the management of the RIA or having a net worth of at least $2 million.

Section 205(a)(1) has also been interpreted as being a barrier to charging contingent fees. A contingent fee is an advisory fee that will be waived or refunded, in whole or in part, if a client’s account does not meet a specified level of performance. The danger with contingent fees is giving RIAs an incentive to speculate or take extraordinary risks to reach the performance necessary to earn a higher advisory fee and avoid losing compensation.

Accredited Investor

The Dodd-Frank Act also changed the definition of an accredited investor. Accredited investors are eligible to participate in certain private and limited offerings, which are exempt from the registration requirements imposed by the Securities Act of 1933. The definition of an accredited investor found in Regulation D includes:

any natural person whose individual or joint net worth with a spouse, at the time of purchase, exceeds $1 million; or

any natural person who had an individual income in excess of $200,000 in each of the two most recent years, or had joint income with that person’s spouse that exceeded $300,000 in each of those two most recent years, and has a reasonable expectation of reaching the same income level in the current year.

On January 25, 2011, the SEC voted to propose amendments to conform the definition of accredited investor to the requirements of the Dodd-Frank Act. Section 413(a) of the legislation amended the definition of accredited investor to exclude the value of a natural person’s primary residence from the $1 million net worth calculation. This exclusion of the primary residence from the calculation took effect as soon as the law passed.

The SEC’s proposed rule will clarify how debt owed on that primary residence is treated in the calculation of net worth. The SEC has proposed that the value of the primary residence should be calculated by subtracting all loans tied to the property. However, these loans may not exceed the primary residence’s fair market value for purposes of calculating net worth. The proposed rule can be found at: http://www.sec.gov/rules/proposed/2011/33-9177.pdf.

Even if a private offering is exempt under the federal securities law, registration may still be necessary in states where the securities are sold. Almost all states have laws regulating the offering and sale of securities. Because of the Dodd-Frank Act, some states must modify their laws. For example, Oregon has promulgated an administrative rule, aligning its definition of accredited investor with how the term is defined in the Dodd-Frank Act.

According to an article published by Jill Radloff, an attorney with Leonard, Street and Deinard, a statute and rule change is not necessary in states like Minnesota. The Minnesota statute’s definition of an accredited investor is based upon how the term is defined in Rule 501(a) of Regulation D. Therefore, Minnesota’s definition of an accredited investor automatically changed upon enactment of the Dodd Frank Act.

The Big Picture

Form ADV disclosure brochures should state specifically whether a firm charges performance fees. Some disclosure brochures are not as clear as they should be. If performance fees will be charged, the conditions for earning them must be articulated clearly in the advisory agreement, and the language must be unequivocal.

Performance-based fees may motivate RIAs to make riskier investments. In order to address this potential conflict of interest, a senior officer of the firm should periodically review client accounts ensuring investments are suitable and that the account is being managed according to the client’s investment objectives and risk tolerance.

Performance fees may also create an incentive for an RIA to overvalue investments that lack a market quotation. Firms should address this type of conflict, by adopting policies and procedures that require the RIA to “fairly value” any investments that do not have a readily ascertainable value.

If performance fees are charged, the risks arising from side-by-side management should be disclosed. Side-by-side management refers to the practice of managing accounts that are charged performance-based fees at the same time as managing accounts, that are not charged performance-based fees.

Side-by-side management can hurt clients who do not pay performance-based fees. For example, the RIA may have an incentive to allocate limited investment opportunities, such as initial public offerings, to clients who pay performance-based fees. Clients paying asset-based fees would miss out on those opportunities. Although an RIA may implement policies and procedures designed to avoid favoring performance-based accounts over asset-based accounts, a potential conflict of interest exists and must be disclosed.

Les Abromovitz

Les Abromovitz is the author of The Investment Advisor’s Compliance Guide, published by The National Underwriter Company/ALM Media.

An attorney and member of the Pennsylvania bar, Les has handled hundreds of consulting and publishing projects for National Compliance Services, www.ncsonline.com, a leading compliance and regulatory services firm. He has conducted a number of seminars and training sessions dealing with compliance subjects. Les is also the author of several white papers that analyze compliance issues impacting Registered Investment Advisors (RIAs)‎.